Trust and Social Collateral

Leveraging social connections as collateral to secure informal loans

This paper builds a theory of trust based on informal contract enforcement in social networks. The paper presents a model in which network connections between individuals can be used as social collateral to secure informal borrowing. The paper defines network-based trust as the highest amount one agent can borrow from another agent.

The paper states that the possibility of losing valuable friendships secures informal transactions the same way that the possibility of losing physical collateral can secure formal lending. Since direct and indirect connections can serve as social collateral, the level of trust is determined by the structure of the entire network.

The paper uses data from Peru, to structurally estimate and test the model, and to show empirically that network-based trust predicts informal borrowing. It demonstrates that:

Dense networks generate social capital that allows transacting of valuable assets;
Loose networks create social capital that improves access to cheap favors like information;
For job recommendation networks, strong ties between employers and trusted recommenders reduce asymmetric information about the quality of job candidates.